Wednesday, October 15, 2014

Volatility has returned to the stock market and most of the gains of 2014 were wiped out in the last week. Is it time to panic? Not yet!

There is a close relationship between changes in the value of the stock market and changes in the unemployment rate one quarter later. My research here, and here shows that a persistent 10% drop in the real value of the stock market is followed by a persistent 3% increase in the unemployment rate. The important word here is persistent. If the market drops 10% on Tuesday and recovers again a week later, (not an unusual movement in a volatile market), there will be no impact on the real economy. For a market panic to have real effects on Main Street it must be sustained for at least three months. And there is no sign that that is happening: Yet.

It is of course, possible, that movements in the stock market are only apparently causal. In reality, the clever people who trade in the markets are prescient in their ability to foresee the very bad fundamentals that are driving the real economy. It is also possible that sometimes, market participants panic and that panic has real consequences when the rest of us find that our houses and pension plans are suddenly worthless. My own theoretical work supports the latter hypothesis but reasonable people can disagree.

So: should you be worried that we are about to enter a double dip recession? In my view, not yet, because, as of right now, the market shows no signs of a persistent drop when measured in real terms. When (and if) the Yellen Fed follows through with its withdrawal of QE; we may be looking at a very different situation. Hang on to your hats!

Thursday, October 9, 2014

I have been slow to chime in on Thomas Piketty’s book, Capital in the 21st Century, but it is hard to ignore the chatter that the book has generated from those on all sides of the political spectrum. The book sheds welcome light on the topic of income and wealth inequality and it has rekindled a debate in the United States and Europe on an age-old question: Should we care if some individuals earn much more than others?

As individuals in a modern democracy we make social decisions about how much of each good to produce and consume through free trade in a market economy. The rules by which we trade with others are determined through democratic elections in which we give power to our representatives to transfer resources from one human being to another. And we interact with each other through conversations, free association and social media or through more organized forms of persuasion such as newspapers and television stations.

As economists, we are sometimes justly accused by other social scientists of taking a narrow view of human nature. A human being, to the neoclassical economist, is a preference ordering over all possible actions that he or she may take over the course of a lifetime. That preference ordering is fixed at birth and swings into action at the age of consent, at which time each of us exercises our endowed ability to choose among competing alternatives to maximize our happiness.

That, of course, is poppycock. The view of homo-economicus as a utility seeking machine is not to be found in Smith, who had a much richer view of human nature as evidenced by his “other book” on The Theory of Moral Sentiments. Nor is it to be found in John Stuart Mill’s eloquent defense of free speech in his essay On Liberty. Both of those eminent social scientists would, I am certain, have been open to the idea that our opinions are formed through rational argument with other human beings. Our preference orderings do determine our actions; but they are not preordained. Nature and nurture are equally important determinants of human action.